Position sizing is not as exciting as identifying the next stock to breakout, but understanding and application of it is essential if you want to be able to continue trading for the foreseeable future. In the simplest terms, it is how much money you are prepared to put into any bet or trade. Most beginners risk far too much, either on single positions or by opening too many active trades, and that contributes to the massive failure rate of novices to the financial markets.
Position sizing comes down to the question of how much you can afford to lose, and how large a spreadbet or contract that equates to. Some traders will keep trading the same amount, say one contract or mini contract in every situation, and this is either inefficient because they do not profit as much as they could, or dangerous as they lose more they should.
It’s not an answer to trade as much as your broker allows, if you are trading a leveraged product. Just because a Forex broker allows you 100:1 leverage does not mean it is safe for you, just that it is safe for him, and he is reasonably sure he will get paid. Whether you have enough funds to carry on trading after he is paid is of little concern to him.
To some extent the amount you can afford to lose will depend on your propensity for risk, but most traders say that you should not be in a position where you could lose more than 2% of your account. Note that this is not the same as saying that you only put 2% of your money in any trade, unless of course it’s a trade where you could lose your whole stake, and only your stake. Some professional traders aim to have only a 1% risk.
You may be wondering why the amount is so small, and the answer is that you can expect to have occasional long runs of losses. Two percent works out to a reasonable chance of not running out of money, even over time. Consider for instance what would happen if you risked losing 10% of your funds on every trade. If you had three losing bets in a row, which happens fairly often, you would lose 30%, but to recover to your original account you would have to make 43% on the remainder. If you had five losses in a row, then you would have to double your remaining stake just to get back to where you started. If you plan on trading for months or years, you are almost bound to have such a run or worse.
So position sizing is all about understanding how much you could lose, and not putting yourself in a bad situation where you must win next time or run out of funds. There are various ways of working out your “expected” losses depending on what you are trading, and it is an exercise you should do every time.